Dividend Reinvesting Explained for Mutual Fund Investors

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Reinvesting Stamp

Mutual Fund Education

Dividend Reinvesting Explained for Mutual Fund Investors

Chris Dumont Dec 02, 2014

Dividend reinvestment plans, or DRIPs, are one of the easiest ways to cut investing expenses and maximize the benefits of compounding. DRIPS allow an investor to reinvest the cash dividends received into more shares of the company that issued the dividend.
DRIPs are an easy and convenient way to put the dividends to good use and it’s usually a free service compared to paying commissions for purchasing the shares otherwise. Mutual fund investors can take advantage of DRIPs and have their dividends reinvested for them.

See also 25 Tips Every Mutual Fund Investor Should Know.

What Is a DRIP and How Can You Get One?

More and more companies are setting up DRIPs, but not all DRIPs are created equal. Some DRIPs are managed by the company itself, but sometimes the cost to the company may be too great and so it will outsource the DRIP to a third party. Another alternative to opening a DRIP is through a brokerage, which is beneficial if a company does not have its own DRIP setup. Some will simulate a company-run DRIP with no fees, but customers should only use them to execute commissioned trades. Some DRIPs allow for an optional cash purchase on top of dividend reinvestment, while others do not.

Be sure to also take a Look Under the Hood of the 10 Biggest Mutual Funds.

Creating a DRIP account does take some time, and the hassles and expenses of setting one up can turn some investors off. Investors should first research to see what companies or mutual funds offer DRIPs and which do not. After that, determine who runs the plan, whether it’s the company or a third party. Finally, you will have to purchase at least one share of the company in order to qualify for a DRIP. If a company does not offer a DRIP, look at your brokerage and see if it offers that service.

The Benefits of Reinvesting Dividends

DRIPs allow dollar cost averaging, which is averaging the price at which the stock is purchased as the stock moves up or down over a period of time. This technique is tried and true and helps to ensure that a dollar cost base for the investor is never the high or the low of the stock. It’s often hard to predict the market’s behavior, and with this technique, fewer shares would be bought when the share price is high, and more shares would be purchased when the share price is low.

It can be next to impossible to predict the bottom and so DRIPs can take out the emotion by automatically investing for you.

Another benefit is that some companies are so eager to sign up investors to their DRIPs that they offer small discounts on their stocks. The incentive for the companies is that they save on their financing costs; instead of sending cash to shareholders they can just simply issue more shares. Company-run DRIPs allow investors to purchase fractional shares, and like mutual funds, DRIPs can be used with little capital. Lastly, with non-broker DRIPs, there is often zero reinvestment costs involved.

The Drawbacks of Reinvesting Dividends

As beneficial as DRIPs can be, there are also downsides. To start, it takes time and paperwork during tax time to readjust your adjusted cost based on an investment that changes every time a dividend is reinvested. Also, with broker DRIPs, only whole shares can be purchased, so any remaining funds will just sit in the investment account inactive and will not be working in your favor.

See also 7 Essential Tax Tips for Mutual Fund Investors.

Dividend reinvesting happens automatically with a DRIP, which can happen when the stock is at a less attractive price; there is no control over the price paid for the stock. Lastly, DRIPs are not diversified and you face the opportunity cost of giving up investing the dividends on your own in another stock.

One misconception about DRIPs is that they are not subject to tax because the investor is not receiving cash. Cash is still technically received, but it was reinvested and as such the dividend is considered to be income and is still taxable. As time passes and the stock potentially increases in value and is eventually sold, there will be capital gains tax paid on the investment as well.

When buying and selling shares directly through a company, there is less liquidity compared to buying and selling stocks on your own. With a DRIP, selling can be quite restrictive; you may be required to wait until the end of the trading day or be required to sell all of your shares when you only wanted to sell a few.

Reasons to Pass on Dividend Investing

DRIP programs are not for everyone. Investors that rely on dividends for income or those who want control over what shares to purchase with their dividends should pass on DRIP investing. Selectively reinvesting dividends gives an investor more control over their investment decisions, and financial flexibility, allowing them to collect dividends in cash and purchase those stocks that they feel are more attractive. With this flexibility it is also easier to time the market, whereas with a DRIP, the shares are given only four times a year on the dividend payout date.

The Bottom Line

DRIPS offer the ease and convenience of capitalizing on the magic of compounding and dollar cost averaging. They take away any maintenance involved and it’s often a free service. Just be aware that there is no single strategy for reinvesting dividends; each investor has their own investment needs and may want more control over their dividend investments. DRIPs just happen to be one way to reinvest dividends so that they in turn can create more dividends.

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